It has now been over a year since oil began its precipitous decline, from prices well over $100 per barrel to its current range in the low to mid-$50s. Pessimism is still incredibly high and just about every investment in anything energy-related has been massacred. It is not just energy prices that have tumbled as other commodities such as iron ore, coal, and copper have been hit very hard. Fears of a hard landing in China are likely a very large contributor to the recent declines, and of course the nuclear deal with Iran will likely lead to additional supplies hitting the market. The strong U.S. dollar is also a huge contributor to the decline in natural resource prices. While it can be frustrating taking hits on energy investments, investing is about looking to maximize returns with the least amount of risk over the next 3-5 year period. Capital expenditures have declined dramatically and the North American rig count is down by roughly 60% from the same time a year ago. After having many years of high energy prices and enormous capital expenditure budgets, it takes time for these slowdowns to impact production and prices, but it unquestionably will. While OPEC is producing at an extremely high rate and shale has been persistently strong, other areas such as Mexico and Latin America are seeing rather steep production declines. Demand is increasing and any change in sentiment, could result in dramatic upside because pessimism is so rampant.
As far as individual investments, the energy sector is ripe with great long-term opportunities, despite the dreary short-term outlook. Many exploration and production companies are down by 50% or more, despite owning tremendous assets and having the financial wherewithal to survive this crisis. Offshore oil rig contractors such as RIG and ESV were just a year ago paying out dividends of $3 per share or more, and are now trading in the teens. These companies are operating in the worst area of the market as offshore is both expensive and oversupplied relative to demand, but they boast strong backlogs and decent balance sheets that should ensure their survival. These are the types of companies that can double or triple over the next 3-5 years, while paying out very large dividends when prices normalize and demand for offshore rigs picks up once again. Other companies such as National Oilwell Varco (NOV) make many of the components that go into rigs and other facets in the drilling and completions industry. The company has a pristine balance sheet, high returns on invested capital, and a strong history of creating value through mergers and acquisitions. The stock trades at about 6 to 7 times normalized earnings, while current earnings are obviously going to be quite depressed. Other exploration and production companies such as Apache, Continental Resources, and Chesapeake Energy have sold off a great deal for many of the same reasons.
Lower energy prices clearly reduce cash flows, profits, and the net asset value of these companies. Because most market participants are short-term oriented and the short-term outlooks is quite clearly uncertain at best, many of these companies trade at very large discounts to their long-term intrinsic value. Investing is about the future and what matters is not where these stocks have gone, but where they are going. As production slows and demand picks up, prices will inevitably rise. Of course the timing of this is impossible to reliably predict. The reality is though that is in year-6 of a bull market, you are not going to find investments that have a very reasonable probability of doubling or perhaps tripling in stocks that don’t have uncertain short-term horizons. This doesn’t mean you load up on energy stocks and you make sure to focus on companies with strong balance sheets, but it does mean that energy investments offer fertile ground for potentially large profits over the next 3-5 years. The key is just being patient with it and understanding that we will never be perfect at picking the bottom. Most energy companies don’t have what I’d describe as a durable competitive advantage (although there are a few exceptions), so we really need to be smart about the price that we are paying. High volatility is to be expected and anyone with energy exposure has the potential to look very silly in this type of environment, but it is just this feeling of pervasive pessimism that leads me to believe that energy is likely to be a significant opportunity for the long-term value investor.